Tax relief on mortgage debt forgiveness ends in 2013, so hurry

Lew Sichelman

The window is closing rapidly on one of the most important tax-relief provisions enacted by Congress during the housing crisis to help financially strapped homeowners.

Although the 2007 law that allows taxpayers to exclude from income the amount of debt that is forgiven or canceled by their lenders doesn't expire until Dec. 31, it's likely to take every bit of the next 11 months for financially troubled homeowners to persuade their banks to either foreclose or allow their houses to be sold for less than they are worth.

Although owners who are struggling to hold on to their homes shouldn't throw in the towel solely because of the pending tax bite, it is certainly something to consider.

Under the tax code, borrowed money need not be reported as income because you have an obligation to repay. But if the lender subsequently cancels what you owe, the IRS requires that you report that debt as income because the duty to repay it no longer exists.

So, if you owe $250,000 and your lender forgives $50,000 of that debt in a $200,000 refinancing, that $50,000 is considered income. If your combined federal and state marginal tax rate is 36%, you would owe $18,000 in taxes.

Under the Mortgage Forgiveness Debt Relief Act of 2007, though, taxpayers are allowed to exclude from income the discharge of debt on their principal residence — at least until 2013.

So when your lender agrees to a short sale, there is no tax on the difference between the selling price and the amount you owe. When your lender forecloses, there is no tax on the canceled debt. Even when you refinance at a lower loan balance, there is no tax on the difference between what you owed on the old loan and what you owe on the new one.

But unless Congress extends the law — and there is no indication lawmakers are even thinking about that — all residential mortgage debt relief that takes place on or after Jan. 1, 2013, will once again be considered taxable income.

Why worry about this nearly a year before the law changes? Because the timelines on debt forgiveness decisions by lenders are absolutely horrendous.

As of October, it was taking lenders an average of 674 days to process a foreclosure, according to Lender Processing Services, a Jacksonville, Fla., mortgage technology firm. That's more than 22 months, or almost two years from the time the process starts to when the property is actually repossessed. And lenders don't even start the process until an average of 391 days after last receiving a payment.

Of course, each state has a different timeline.

There are no hard and fast numbers when it comes to short sales or refinancings. But they also can be long, drawn-out transactions.

According to a nearly year-old survey by Equi-Trax Asset Solutions, a Santa Barbara analytics company, it can take four to nine months for underwater borrowers to persuade their lenders to sign off on a deal in which the lender will net less than what the borrower owes.

Eighteen percent of the 600 agents polled said short sales can be closed in less than three months if the stars line up just right. But almost 10% said these transactions require more than 10 months to complete.

A refinancing that involves principal amnesty is probably the quickest of the three debt-forgiveness scenarios. At Carrington Mortgage Services, a Santa Ana-based lender licensed in 32 states, a "short-refi" takes 45 to 60 days.

There are many factors besides a tax break to consider when deciding whether to give up your house. What will a foreclosure or short sale do to your all-important credit score? How long will you be precluded from buying another house? Will the extra income push you into a higher tax bracket?

As always when it comes to such matters, you should consult a tax professional before making any decisions.

Here are a few of the other important rules that you and your tax person need to know:

• The debt-relief law applies only to debt incurred to buy, build or improve a personal residence.

• The law does not apply to vacation homes or investment properties.

• The maximum amount you can treat as indebtedness is $2 million, or $1 million if you are married but filing separately.